Readers with teenage children or young adult kids may be familiar with the following complaints. They’ll be the first generation ever that will be poorer than their parents and grandparents. They are so priced out of home ownership that it isn’t even something they think about.

Jobs are far less secure than in the past with none of the defined pension benefits that mum or dad got, while free public services once taken for granted may not remain so down the line. This makes their futures far more uncertain than generations of the past. And soon, these economically disadvantaged youngsters will also be outnumbered by their elders, presuming the demographic tides keep tilting as they are now.

Whatever criticisms might be batted back against Millennials or iGens (a termed coined by psychologist Jean Twenge to describe those born after 1995 for their ubiquitous use of iPhones) – workshy, unambitious, self-obsessed – most would accept that there is at least a nub of truth in youngsters’ grievances.

Yet they have one crucial advantage - time. And this matters when investing for your future like little else thanks to the power of compounding, that mathematical marvel which Einstein called ‘the eighth wonder of the world’.

WHAT IS COMPOUNDING?

Compounding is the process by which an investment’s returns, either from capital gains, income, or both, are reinvested to generate additional returns over time. ‘It’s like a snowball being rolled down a hill: it starts off small with not much extra snow added, but the bigger it gets the more snow it gathers’, says Charles Stanley chief analyst Rob Morgan.

‘The further the snowball goes the more powerful the effect, which is why time plays such a big factor in compounding.’

Let’s illustrate this with a simple example. Let’s say you invest £100 at a 10% annual return. After one year, you now have £110. Which means next year’s 10% return is earned on £110, becoming £121, year three’s 10% is earned on £121, so becomes £131.10, year four becomes £146.41, then £161.05 after year five.  

That annualised five-year return works out at 12.2%, 2.2 percentage points better than the 10% a year at which you have been investing over the five years.

‘Money makes money. And the money that money makes, makes money’, said Benjamin Franklin, capturing the allure of compounding returns perfectly.

REALISTIC MARKET RETURNS

In real life, you are unlikely to get 10% returns every year on any investment - average stock market returns, according to Barclays’ Equity Gilt Study, are more like 5% to 6% based on decades of return data from all over the world.

And while stocks have historically been one of the best performing asset classes, the returns they provide can be volatile, with smaller and larger annual returns sprinkled with other years of losses. But this is why compounding returns are so valuable to investors, says Coutts chief investment officer Alan Higgins.

What’s striking with the compounding effect is how patiently accruing modest returns can lead to excellent long-term results.

‘Over time, compounding your returns by simply leaving them invested could help you ride through any market volatility’, Higgins says. Time in the market, not timing the market, as they say, and that means you could end up with a pension pot worth far more than you put in.  

So, while you won’t see the benefits of compound returns overnight, building slowly and taking a long-term investing approach really matters. And just because you don’t have thousands of pounds to invest need not stop you getting that ball rolling.

As our data shows, even relatively small sums invested regularly over years can build up into a large pot. And you wouldn’t expect your salary to stay the same in future, so increasing your contributions as your earnings improve can really soup up the long-term outcome.

What you want to avoid to is reaching too far to quickly for higher returns which can make you come unstuck. Doubling your money in a year would probably involve taking a very high level of risk, most probably casino-like. However, doubling your money over 10 years is much more attainable. You need a return of just over 7% a year.

For example, if you were to invest £5,000 a year into a diversified portfolio with a 5% annual growth rate into your pension from 20 years of age, you would have a portfolio of £838,426 if you were to retire at age 65. Alternatively, if you were to wait until you are 35 to save into your pension based on the same growth rates and with the same retirement date in mind, you would have a retirement pot of just £348,804. Start at 45 and your retirement pot would be down at £173,596.

Compounding can make a big difference when it comes to giving your kids a financial leg up. If a family invests £3,000 a year (£250 a month) for their newborn daughter into a diversified equity portfolio, by the time she is 25 they will have invested £75,000 in total. If this portfolio achieves a 5% annual growth rate over this period and all dividends are reinvested, she will receive another £75,340 just from compounding the investment returns. In other words, at age 25 she will have £150,340, a fair chunk to pay off university fees and provide a lump sum for a mortgage.

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